Philip Morris Q3 Earnings Preview: What Nobody Is Talking About (NYSE:PM)

Introduction

Philip Morris International (NYSE:PM) is the undisputed leader in smoke-free products – thanks to relentless internal research and development, the very astute acquisition of Swedish Match, and shrewd deal making with Altria Group (MO). However, the company’s leadership position is widely recognized, which is the main reason PM stock trades at a significant premium to its peers.

At the same time, given that the stock has essentially gone nowhere since early 2021, investors need to recognize that the company got cheaper over time as earnings, cash flow, and prospects improved (e.g., PMI’s re-entry into the U.S. was unknown at the time). And with the tobacco giant regularly beating quarterly EPS estimates and set to report its third quarter numbers on Thursday, Oct. 19, at about 7 a.m. Eastern, it’s likely that the stock is getting a little cheaper once again.

In this update (I cover PMI stock regularly), I share my expectations for the upcoming earnings report and my updated valuation.

However, as investors focus almost myopically on PMI’s undoubtedly solid growth prospects, I also will take a close look at the company’s debt. While U.K. competitor British American Tobacco plc (BTI, OTCPK:BTAFF) suffers from seemingly unending bearish sentiment (largely due to its high U.S. dollar debt), PM stock is holding up very well – despite a significant mismatch between U.S. dollar sales and U.S. dollar debt, a 90% increase in net debt since 2021, and an increasingly likely “higher for longer” interest rate environment.

How Were Philip Morris’ Previous Earnings And What To Expect From Q3 Earnings?

Philip Morris exceeded earnings per share expectations by a more or less significant margin in every single quarter over the past four years (Figure 1). Sales estimates were exceeded in 13 of 16 quarters, but in the few cases where Philip Morris missed expectations, the deviation was insignificant.

For the recently completed quarter, analysts expect earnings per share of $1.62, representing year-over-year growth of 5.6%. This is solid growth considering the challenging environment where consumers are increasingly switching to discount brands in the face of high inflation. The consensus estimate for net sales is $9.22 billion, up nearly 15% from Q3 2022, and with the Swedish Match transaction digested and Philip Morris successfully establishing IQOS in the U.S., EPS growth is expected to accelerate: Between Q3 2023 and Q4 2025, analysts expect average quarterly EPS growth of 13.1%. From 2024 through 2027, average annual EPS growth is currently expected to be 9.4% – PMI is clearly not a company in decline.

Given the more or less significant positive EPS surprises (7.0% ± 5.7%) and the rather insignificant EPS and revenue revisions in recent months, an earnings beat on Thursday is a reasonable expectation. However, Philip Morris held its Investor Day event on Sept. 28, 2023, and pointed to a $0.17 negative currency impact, two-thirds due to the strengthening of the U.S. dollar and one-third due to balance sheet-related impacts in Argentina. As a result, adjusted earnings per share guidance has been reduced slightly by 3% and is expected to come in at the lower end of the range of $1.60 to $1.65. Considering that the event was held only two days before the end of the quarter, it’s unrealistic to expect a significant improvement, and therefore this will likely be one of those quarters where PMI beats the estimate by only a small fraction.

PMI’s adjusted operating profit margin for the third quarter of 2023 is expected to be about 41.5%, which is in line with the third quarter of 2022 but slightly better than the second quarter of 2023, when profitability improved 2.1% from the first quarter to 39.4%.

PMI expects to ship approximately 32 billion Heated Tobacco Units (HTUs) in Q3, or between 125 and 130 billion HTUs for the full year. Management is obviously very confident about the growth prospects of its heated tobacco business, even though the launch in Taiwan has been delayed and the already proposed ban on flavored heated tobacco in the EU (June 2022) is currently being implemented. In my opinion, this says a lot about PMI’s market-leading position not only in devices but also in conventional, tobacco flavored HTUs. That said, management has cautiously pointed to inventory uncertainties as its trading partners adjust to the ban.

Philip Morris’ Debt – Caution Advised?

The acquisition of Swedish Match, without a doubt, was a very smart move (see this article). It should be remembered, however, that Philip Morris took on a significant amount of debt to fund the Swedish Match acquisition and be in a position to pay Altria the $2.7 billion consideration to exclusively market IQOS in the U.S. starting next year in May. Philip Morris currently has about $44 billion in net debt on its balance sheet (Figure 2), which is 90% more than it had before the bold but undoubtedly brilliant moves it made to solidify its position as the market leader in smoke-free products.

The company generates modest interest income (Figure 3) due in part to its sizable cash balance ($3.5 billion), but nonetheless net interest expense increased 88% year-over-year to $527 million in the second half of 2023. For the full year, investors should expect net interest expense to continue to rise, driven by recent debt raised and, of course, the high interest rate environment.

Philip Morris’ weighted-average all-in financing cost of its debt in 2022 was 2.5%, 10 basis points higher than the previous year. However, looking at the current numbers (p. 48, 2022 10-Q2) and conservatively ignoring interest income, the company’s weighted-average interest rate is 3.9%. This is far from what I would call worrisome, but it’s still important to look more closely at two aspects – the maturity profile and currency composition of PMI’s debt.

The current maturity profile of PMI’s debt, based on data in the 2022 10-K and including debt issuance in the first six months of 2023 (p. 50, 2022 10-Q2), is shown in Figure 4. Clearly, the company faces significant maturities in the coming years with weighted-average interest rates well below the current weighted-average rate for its total long-term debt (about 3.6%). As an aside, the difference of around 30 basis points to the company-wide rate (see above) is due to more expensive short-term debt.

Of course, if interest rates do remain higher for longer, the company will have to refinance a significant portion of its upcoming maturities at comparatively unfavorable rates, which will impact debt service capacity, earnings and free cash flow. If we conservatively assume that interest rates remain at current levels for five years and Philip Morris refinances its long-term debt at the current rate of its long-term bonds (approximately 6.5%), the company’s interest burden increases by approximately 50%, excluding the contribution of short-term debt (14% of total debt at the end of the second quarter). Put in relation to free cash flow (which is expected to be rather weak in 2023 due to the aforementioned currency headwind), PMI’s interest coverage ratio would decline from 6.9 times free cash flow before interest to 5 times.

Even though the decline in the interest coverage ratio looks serious, I would not overinterpret it. After all, free cash flow should recover significantly once the Swedish Match integration is completed, the heated tobacco business becomes profitable in the U.S. (remember that HTUs are much more profitable than traditional cigarettes), and the synergies between Swedish Match and IQOS are realized. In addition, I think it’s reasonable to expect PMI’s capital expenditures as a percentage of operating cash flow to decline over the years, given the company’s significant investments over the past decade (see this article). All in all, I’m confident in Philip Morris’ strong growth prospects and hence do not consider its currently rather pronounced leverage concerning. This also is evident from the company’s growth targets for 2024 to 2026, which were highlighted during the Investor Day event (e.g., adjusted operating income CAGR of 8% to 10%).

In addition to considering a “higher and longer” interest rate scenario, it’s also worth looking at the currency composition of PMI’s debt. In the event that the U.S. dollar continues to appreciate against other currencies (or PMI theoretically fails to gain a foothold in the U.S.), interest costs will rise due to the high proportion of U.S. dollar-denominated debt (68%, including short-term debt, Figure 5). Still, I would not over-interpret this risk as PMI has an obviously experienced and savvy treasury department. Prior to the Swedish Match acquisition, the company had de facto no sales in U.S. dollars, but still had adequate currency risk management. With Swedish Match’s sales growing (approximately $2.1 billion in 2022), IQOS slowly gaining a foothold in the U.S., and assuming Philip Morris can indeed leverage Swedish Match’s supply chain infrastructure for IQOS, the company’s currency risk will gradually decline, which should ultimately dampen earnings volatility.

PM Stock Valuation

According to Seeking Alpha’s quant system, PM stock is undervalued based on several metrics (Table 1). According to FAST Graphs (Figure 6), Philip Morris International stock is currently trading at a blended price-to-earnings ratio of 15. Based on current earnings estimates, the stock has a potential annual return of 13% through 2025. While this is significantly less than its peer British American Tobacco, I believe PMI’s growth prospects are much more solid and its risks are lower. Of course, this should not be taken to mean that I think British American is an overly risky or poor investment – quite the contrary, my regular readers know that I have a significant position in BTI stock.

Finally, PMI stock is also quite favorably valued from a free cash flow perspective. In 2023, free cash flow suffers from currency headwinds, but with the growing contribution from Swedish Match, synergies potential, and the expected launch of IQOS ILUMA in 2025, a return to significant growth is likely. As PMI has cemented its leadership position over the years, I also suspect that capital expenditures will gradually decline below previous levels, which also will support free cash flow growth. According to Figure 7, PMI stock would be fairly valued at $128 per share, representing upside potential of 37% based on stated growth rates and a cost of equity of 9% (brief sensitivity analysis included in the figure).

Summary And Conclusion

Philip Morris will announce its third quarter results on Oct. 19 before the stock market opens. Although the company has regularly beaten estimates for quarterly earnings per share by more or less a wide margin in the past (7.0% ± 5.7%), I don’t expect a big surprise on Thursday. The company held its Investor Day event just two days before the end of the third quarter, so recent guidance is well reflected in consensus estimates. Still, I expect a small positive surprise given management’s typically cautious comments and its tendency to under-promise and over-deliver.

Longer term, PMI’s prospects are obviously very good and intact. This is underscored, for example, by the fact that management still expects HTU sales of about 32 billion in Q3 2023 – despite the ban on flavored heated tobacco products currently being implemented in the European Union. Longer-term shipment guidance of 180 to 200 billion HTUs and 800 million to 1 billion nicotine pouch cans in 2026 also confirm the strong growth path.

Investors also should watch for an update on the Pre-Market Tobacco Product Application (PMTA) for IQOS ILUMA (the induction-based successor to the conventional, blade-based design) that management recently announced for October 2023 (expected approval 2025). However, the conventional design will still be introduced in select U.S. cities starting in May 2024 for testing purposes (after Altria’s exclusive distribution rights end), but I suspect this technologically inferior system will not be sold nationwide.

But while PMI is clearly a leader in smokeless products and has excellent growth prospects, it’s important not to forget the sharp increase in debt, largely due to the acquisition of Swedish Match and the consideration paid to Altria for regaining exclusive distribution rights in the United States.

Philip Morris’ net debt has nearly doubled since 2021, and the weighted-average time to maturity of its long-term debt declined from 10 years at the end of 2021 to just over eight years at the end of the second quarter of 2023. Given its relatively high dividend payout ratio (70% to 90% of free cash flow), PMI will need to refinance most of its debt at maturity. If we assume interest rates remain at current levels for five years, the interest expense on PMI’s long-term debt will increase by approximately 50%. As a result, interest coverage would drop from about 7x pre-interest free cash flow to 5x. In addition, PMI is significantly dependent on U.S. dollar-denominated debt, which further increases potential pressure on the company’s debt service capacity given the still very low level of sales in the United States. Finally, investors should keep in mind that Philip Morris is, after all, a tobacco company, and it increasingly looks like such companies – along with oil & gas companies, for example – pay a more or less significant “ESG premium” on their debt (see my analysis here).

However, due to excellent fundamentals and expected strong free cash flow growth, I believe PMI is well positioned to weather a potentially longer-term high interest rate environment. With Swedish Match’s sales growing (about $2.1 billion in 2022), IQOS slowly gaining traction in the U.S., and assuming Philip Morris can leverage Swedish Match’s supply chain for IQOS, the company’s currency risk will decrease, and with it the need for potentially costly hedges.

Given PMI’s undoubtedly strong prospects, the compelling roadmap presented at the investor day, and manageable debt levels even in a persistently high interest rate environment, I think the stock is a solid buy in the $90 range.

Thank you for taking the time to read my latest article. Whether you agree or disagree with my conclusions, I always welcome your opinion and feedback in the comments below. And if there’s anything I should improve or expand on in future articles, drop me a line as well. As always, please consider this article only as a first step in your own due diligence.